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On Our Radar

Amazon's Secret Weapons in Music Streaming

The on-demand music streaming market is getting increasingly crowded. Spotify had a head start on just about everyone, but Apple(NASDAQ: AAPL) and Tidal have been able to make some headway over the past 18 months or so. Pandora(NYSE: P) announced its plans to launch an on-demand service by the end of the year last month, taking advantage of its huge listener base.

Now Amazon(NASDAQ: AMZN) has come to play. And in typical Amazon fashion, it's undercutting the competition's pricing. Prime members can subscribe to Amazon's recently launched service -- Amazon Music Unlimited -- for just $8 per month. Paying for a year upfront costs just $79 -- $6.58 per month. If you only want to listen to music on your Amazon Echo speaker, you can do so for just $4 per month.

Other companies have tried to break the $10 per month barrier before, believing a much larger portion of the market is willing to spend somewhere between $5 and $10 per month on unlimited music streaming. Only Amazon has been able to pull it off.

Amazon is willing to take a loss

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Even at an effective rate of $6.58 per month, Amazon is still sending about $7 per month to record labels.(That's the same as its competitors send for their $10-per-month services.) On top of that, Amazon has operating expenses for the service. (But considering it owns the cloud infrastructure it runs on, it gets a bit of a discount.)

The key to the whole operation is Amazon Prime. That's one of the secret weapons none of Amazon's competitors have.

Pandora and Spotify have millions of free users to funnel into their paid services. But neither of them are willing to take a loss on their paid service. It's their premium offering, and should, therefore, have significantly higher margins than the standard offer.

Apple, meanwhile, is using Apple Music subscriptions to offset the decline in digital downloads. Instead of using it as a loss leader for hardware sales, it's looking to generate similar margins as iTunes.

Amazon, however, is positioned to provide on-demand streaming as an incentive to sign up for Prime. Not only does Music Unlimited provide yet another way for Amazon to onboard new Prime members, it makes Prime subscribers more likely to renew their subscription thanks to the bundling discount.

Bending the rules of the game

What might be more interesting is the $4 per month Echo-exclusive service. It's unclear what kind of deal Amazon struck with the record labels, but it's highly unlikely it's paying the same royalty for the Echo service as for Music Unlimited.

The $4 per month price point undercuts even Pandora's new Pandora Plus ad-free radio service. The voice-only user interface doesn't lend itself to browsing Amazon's catalog, but allows users to queue up just about any song that comes to mind. Pandora Plus is just a lean-back listening experience.

Again, it's possible -- even likely -- Amazon is taking a loss on the Echo streaming service, hoping to make up for the loss with hardware sales. The company has sold over 4 million of the smart speakers so far,and it plans to sell 10 million more next year. The Echo-only plan could do a lot to boost sales.

Echo speakers also give Amazon another touch point to connect with customers, which adds value to its core retail service.

What happens now?

It's unlikely Amazon steals away a significant portion of Spotify or Apple Music users. Even heavy Pandora radio listeners may be better suited paying up for the company's upcoming on-demand service.

But Amazon has the potential to take a significant share of the market that hasn't yet started subscribing to on-demand music services. Market penetration for on-demand streaming is less than 10%, with music aficionados being the early adopters. The average consumer spent just $73 on music last year if you don't count live events.And did I mention one year of Music Unlimited costs just $79?

With 40 million to 50 million Prime households in the United States (a number that's growing rapidly), it has a huge customer base to market its new service to at a huge discount to the competition. What's more, this could be the push some customers need to sign up for Prime in the first place or buy an Echo smart speaker.

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Adam Levy owns shares of Amazon.com and Apple. The Motley Fool owns shares of and recommends Amazon.com, Apple, and Pandora Media. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.